'It's like you gotta buy something, so you hold your nose and buy it'

By the time Chicago billionaire Sam Zell appeared on the scene in 2007 with his proposal to take Tribune Co. private, the red-hot market for corporate loans was primed and ready to accept him.

Bankers eager for profits were funding leveraged buyouts at a rapid pace, and as the boom cycle advanced, lending standards loosened.

As strange as it may seem, however, a substantial portion of the new money flowing into the market for high-risk buyouts was coming from some of the financial system's most conservative big-money players — billion-dollar pension funds and other institutional investors.

At a time when low interest rates had depressed returns on traditional AAA investments like money market funds, experts say these massive investors were turning to a relatively new kind of investment: collateralized loan obligations, or CLOs, that promised a razor-thin advantage.

The dynamic was analogous to what was happening in the housing market. Banks and other lenders were making ever-more-risky loans that they sliced up and sold to other financial firms that, in turn, reconstituted them into new combinations called structured securities. These investments blended together pieces of many deals in a diversified pool that theoretically lessened the overall risk by blunting the impact of any one default.

Each CLO was structured to offer investors the choice of different levels of risk and potential reward. Typically, according to Steven Miller, managing director of S&P Capital IQ Leveraged Commentary & Data, ratings agencies like Moody's and Standard & Poor's granted the highest ratings to the top two-thirds of the pool of loans in a single CLO and lower ratings to the riskier portions below.

Big institutional investors gravitated to the AAA levels, which provided slightly higher returns than other, similarly rated investments. The result: Getting involved in a corporate takeover could now be rated as safe as buying a U.S. bond.

"As long as you could magically produce these risk-free returns, institutions flooded in," said Amir Sufi, an expert in leveraged finance at the University of Chicago Booth School of Business.

From 2003 to the peak in 2006, according to Miller, CLO volume shot from $16 billion annually to $97 billion, providing a voracious set of customers for the risky loans that banks were originating.

For Wall Street's biggest banks, like Citigroup and JPMorgan Chase, syndicating loans was nothing new. What juiced up the market was the fresh capital from this new class of investor. The demand for deals was extraordinary, encouraging a gradual erosion in lending standards, deal by deal, as the process of generating loans and selling them into the marketplace became nearly automatic.

Banks did expose themselves to significant risk, but only for the short period between issuing the loan and passing most of it on to investors. In return, they got paid exceptionally well.

For many, the risk of not participating in a deal appeared much more perilous than the seemingly faint risk of getting stuck unable to sell a loan.

At the firms that structured and managed CLOs, the process of churning out offerings also became automatic — locking in new investment, buying slices of new loans and collecting big fees.

One big difference between the corporate market and mortgages was that the volume of individual new corporate loans was smaller. Yet to satisfy the complex formulas that created the AAA rating, each CLO needed a diverse portfolio of loan slices.

That, according to several CLO managers, meant competition to buy slices of leveraged-buyout debt was fierce. Often deals attracted a surplus of buyers, and managers would jump at the chance to invest, sometimes after only a day's worth of cursory research.

One manager who bought a slice of the Tribune Co. deal said he thought it had way too much debt relative to equity but invested anyway because the banks priced it aggressively enough to make it fit into his overall portfolio mix.

"It's like you gotta buy something," he said, "so you hold your nose and buy it."